I wrote about the turn in emerging markets in a Macro Wrap post almost 2 months ago:
The verdict is still out on whether this is just another short-lived bounce for FXI, EEM, and the related stocks, or whether this particular rally has more staying power. Relative valuation has favored emerging market stocks over developed market stocks for a long time now (our Macro Wrap post from August compared the valuations of some of the mega cap stocks in the U.S. vs. EMs, illustrating that differential). Psychology and sentiment has stymied incremental rotation into emerging markets during the past few years, however, so relative valuations have not mattered much.
Whether the current rotation into EM picks up pace or not, the longer-term opportunity seems squarely in favor of emerging markets. Timing is always the wild card, as no one will tap us on the shoulder to say, “Ok, now the coast is clear.” For now, despite the strong rally, most emerging market stocks are still negative on the year, so portfolio managers are not strongly incentivized to chase rallies here. That could change if the current strength continues.
Since then, EEM has continued its rally from the March lows, and is now positive on the year. While many emerging market stocks are now overbought, and the short-term trade is less clear, I view the recent outperformance of EEM vs. SPY as a much more important long-term shift. Here is the SPY / EEM ratio over the last 10 years:
The chart looks like a false breakout to a 8 year high above the 4.40-4.50 resistance area, and the ratio is now back below that area. Given that fundamental valuations are much more attractive in emerging markets, and given the significant underweight positioning in EM that persists among global portfolio managers, my hunch is that emerging market outperformance is going to be a multiyear theme going forward.
Long-term investment exposure in beaten down markets like Russia (RSX) on broader pullbacks in emerging markets makes sense to me. After 3 years of SPX outperforming emerging markets, it feels like the roles have finally reversed.